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Europe’s top banking regulator has raised concerns about the “circles of risk” being created by banks providing financing to investors that are taking on credit risk from other lenders.
The European Banking Authority said in a report on Friday that it was “paramount to understand” whether loan exposures transferred out of the banking system through a fast-growing credit-transfer market were looping back through financing from other lenders.
The EBA’s concern stems from the rapidly growing market for significant risk transfers — also known as synthetic risk transfers, or SRTs — in which investors take on credit risk from a bank’s loan portfolio in return for regular payments from the lender.
Banks across the EU have been issuing increasing amounts of SRTs, which allow them to reduce the perceived riskiness of their balance sheets, freeing up capital to fund more lending or return to shareholders.
The EBA said: “It remains paramount to understand whether banks are, for instance, investing in private credit funds or other [non-bank financial intermediaries] that then invest in banks’ SRTs.”
“This could create certain ‘circles of risks’, as in the end a private credit fund’s SRT investment would become an implicit risk for a bank that invests . . . in that fund.”
The warning reflects intensifying scrutiny of SRTs by global regulators. The IMF warned last year about the risk of “round-tripping” as it pointed to “evidence that banks are providing leverage for credit funds to buy credit-linked notes issued by other banks”.
The Bank of England said in April that it had observed “an imprudent approach” in how banks were classifying the financing they provide via repurchase agreements — or repo — to investors against the SRTs they buy from other banks.
US Federal Reserve chair Jay Powell told the Senate banking committee in February it was checking “on a case-by-case basis” to see if SRTs “really do transfer risk successfully”.
The EBA said SRTs made up just over half the €1tn of total securitisations issued by EU banks. Its survey of banks found more than half had used SRTs already and three-quarters aim to do so in future. SRTs cover about 2 per cent of all credit risk in EU banks.
Loans to small-and-medium-sized companies made up just over 30 per cent of the risk transferred through SRTs across the bloc. Loans to larger companies made up a similar proportion, while a quarter covered residential or commercial mortgages.
SRTs seem to be helping banks increase shareholder distributions. The EBA said EU banks’ dividends and share buy-backs were expected to rise from €92bn this year to €108bn next year, lifting their payouts from 51 per cent of total earnings to 55 per cent.
Overall the EBA said the region’s banking sector “continues to show resilience” after profits rose 9 per cent last year and capital stayed close to a record high with an average common equity tier 1 ratio — a key regulatory benchmark that measures a bank’s financial health — of 16.1 per cent. But after non-performing loans rose from a recent low it warned “geopolitical events could pose significant challenges for the industry”.